Download externalities and property right and more Lecture notes Economics in PDF only on Docsity!
Chapter 10 Externalities and
Property Rights
A droll television ad for a British brand of pipe tobacco opens with a dis- tinguished looking gentleman sitting quietly on a park bench, smoking his pipe and reading a book of poetry. Before him lies a pond, unrippled except for a mother duck swimming peacefully with her ducklings. Suddenly a raucous group of teenage boys bursts onto the scene with a remote-controlled toy warship. Yelling and chortling, they launch their boat and manoeuvre it in aggressive pursuit of the terrified ducks. Interrupted from his reverie, the gentleman looks up from his book and draws calmly on his pipe as he surveys the scene before him. He then reaches into his bag, pulls out a remote control of his own, and begins manipulating the joystick. The scene shifts underwater, where a miniature submarine rises from the depths of the pond. Once the boys’ boat is in the sub’s sights, the gentleman pushes a button on his remote control. Seconds later, the boat is blown to smithereens by a torpedo. The scene fades to a close-up of the tobacco company’s label. Many transactions generate costs or benefits that accrue to people not directly involved in those transactions. These effects are often unintended. They are called external costs and benefits — externalities, for short. From the pipe smoker’s point of view, the noise generated by the marauding boys was an external cost. And had others been disturbed by the boys’ rowdiness, they may well have regarded the pipe smoker’s retaliatory gesture as an external benefit. The boys will have a different view of the situation. If the smoker has his tranquillity, they cannot have the fun they derive from their toy warship. The boys can argue that the smoker’s tranquillity imposes a cost on them for which they are not compensated. Thus the problem is reciprocal, and it is the problem of scarcity. If the smoker has his tranquillity, the boys are deprived of their recreation. If the boys have their rec- reation, the smoker is deprived of his tranquillity. (Surely, there is no real threat to the ducks. They can easily fly away.) The pond cannot simultaneously provide recreation for the boys and tranquillity for the smoker and others. How is the pond to be allocated between its competing uses? There is no market through which an answer can be provided. There is no mechanism that will enable the smoker to pay the boys to go away, or for the boys (or their parents) to pay the smoker to be tranquil somewhere else. For one thing, it appears that neither of the two parties has the right to demand and receive payment. Besides, other users of the pond
C H A P T E R O U T L I N E
10.1 How External
Costs and Benefits
Affect Resource
Allocation
10.2 Property Rights
and the Tragedy
of the Commons
10.3 Environmental
Policy and
Externalities
10.4 Positional
Externalities
304 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
are affected too, and it seems quite impractical to include them in negotiations about the pond. We must also question the smoker’s method of determining how the pond will be used. Can a society function well if decisions about resource allocation are resolved by blowing up property or by relying on other forms of violent conflict? This chapter focuses on how externalities affect the allocation of resources and on methods of resolving the problems caused by externalities. Adam Smith’s theory of the invisible hand applies to an ideal marketplace in which exter- nalities do not exist. Smith’s structure included a system of justice that secured everyone’s right to pursue his or her self-interest on equal footing with everyone else. In such situations, Smith argued, the self-interested actions of individu- als would lead to socially efficient outcomes. We will see that when the parties affected by externalities can easily negotiate with one another, the invisible hand can still produce an efficient outcome. But in many cases, such as the scene depicted in the tobacco ad, negotiation is impractical. In those cases, the self-interested actions of individuals will simply not lead to efficient outcomes. Because externalities are widespread, the attempt to forge solutions to the problems they cause is one of the most important rationales not only for the existence of government but also for a variety of other forms of collective action, including compliance with norms of behaviour.
10.1 (^) HOW EXTERNAL COSTS AND BENEFITS
AFFECT RESOURCE ALLOCATION The way that externalities distort the allocation of resources can be seen clearly in the next several examples.
external cost (or negative externality) a cost that arises from an activity undertaken by an individual, firm, or other economic agent and that is borne by others because the cost is not incorporated in market prices the agent pays
external benefit (or positive externality) a benefit received by others that arises from an activity undertaken by an individual, firm, or other economic agent for which the agent is not compensated in the market price paid for the good or service involved
externality an external cost or benefit of an activity
external cost (or negative externality) a cost that arises from an activity undertaken by an individual, firm, or other economic agent and that is borne by others because the cost is not incorporated in market prices the agent pays
external benefit (or positive externality) a benefit received by others that arises from an activity undertaken by an individual, firm, or other economic agent for which the agent is not compensated in the market price paid for the good or service involved
externality an external cost or benefit of an activity
EXAMPLE 10.1 Does the honeybee keeper face the right incentives? (Part 1)
Phoebe earns her living as a keeper of honeybees. Her neighbours on all sides grow apples. Because bees pollinate apple trees as they forage for nectar, the more hives Phoebe keeps, the larger the harvests will be in the surrounding orchards. However, apple blossoms produce little nectar, so bees produce little honey when they forage on apple blossoms. If there is no way for orchard owners to compen- sate Phoebe for pollination and if she takes only her own costs and benefits into account in deciding how many hives to keep, will she keep the socially optimal number of hives? For the orchard owners, Phoebe’s hives constitute an external benefit. If she takes only her own personal costs and benefits into account, she will add hives only until the added revenue she gets from the last hive just equals the cost of adding it. But since the orchard owners also benefit from additional hives, the total benefit of adding another hive at that point will be greater than its cost. Phoebe, then, will keep too few hives.
EXAMPLE 10.2 Does the honeybee keeper face the right incentives? (Part 2)
As in Example 10.1, Phoebe earns her living as a keeper of honeybees. But now her neighbours are not apple growers but an elementary school and a nursing home. The more hives Phoebe keeps, the more students and nursing home residents will be stung by bees. If Phoebe takes only her own costs and benefits into account in decid- ing how many hives to keep, will she keep the socially optimal number of hives? For the students and nursing home residents, Phoebe’s hives constitute an external cost. If she considers only her own costs and benefits in deciding how
306 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
Externalities thus distort the allocation of resources in an otherwise efficient market. When externalities are present, the individual pursuit of self-interest will not result in the largest possible economic surplus. And when it does not, the out- come is by definition inefficient.
THE COASE THEOREM To say that a situation is inefficient means that it can be rearranged in a way that would make at least some people better off without harming others. Such situa- tions, we have seen, can be a source of creative tension. For example, we saw that because monopoly pricing results in an inefficiently low output level, the potential for gain gives monopolists an incentive to make discounts available to price-sensitive buyers. And, when orchard owners want more pollination than beekeepers will provide on their own accord, orchard owners have an incentive to pay beekeepers to locate hives near their orchards. If beekeepers want access to crops that do not require pollination by honeybees but that produce abundant nectar, they have an incentive to pay crop owners for access to the crops. Side payments from orchard owners to bee keepers can increase the number of hives near orchards, and remedy any under-supply of hives.^1 Side payments are payments by one party to another as compensation for an external cost or benefit. The next examples illustrate how the inefficiencies that result from externalities create incentives for remedial action.
www.hmco.com/hmco/ college/economics/taylor/ micro/student/exercise/ mitaylor/coase.htm Coase Theorem
www.hmco.com/hmco/ college/economics/taylor/ micro/student/exercise/ mitaylor/coase.htm Coase Theorem
side payment a payment made by one party to another in compensation for an external cost or benefit
side payment a payment made by one party to another in compensation for an external cost or benefit
(^1) Beekeepers and orchard owners frequently pay each other for provision of pollination and access to crops. In fact, in Canada, 92 661 hives were rented in l998 at prices that ranged from $40 to $108, vary- ing by location and season. See Agriculture and Agri-Food Canada Market and Industry Services Branch, Horticulture and Special Crops Division, “The Value of Honey Bee Pollination in Canada,” Hivelights , vol. 14, 15–21 November 2001. If a market is established so that side payments are consistently possible, the externality is internalized. It is no longer an externality. Stephen N.S. Cheung, “The Fable of the Bees: An Economic Investigation,” The Journal of Law & Economics , v. 16, April 1973, pp. 11–33.
EXAMPLE 10.3 Will Chabar dump toxins in the river? (Part 1)
Chabar’s factory produces toxic waste. If Chabar dumps the waste in the river, he causes damage to Fitch, a fisherman located downstream. The toxins are short- lived and cause no damage to anyone other than Fitch. At a cost, Chabar can filter out the toxins, in which case Fitch will suffer no damage at all. The relevant gains and losses for the two individuals are listed in Table 10.1.
TABLE 10. Costs and Benefits of Eliminating Toxic Waste (Part 1) With filter Without filter
Gains to Chabar $100/day $130/day
Gains to Fitch $100/day $50/day
If the law does not penalize Chabar for dumping toxins in the river, and if Chabar and Fitch cannot communicate with one another, will Chabar operate with or without a filter? Is that choice socially efficient? Since Chabar earns $30/day more without a filter than with one, his natural incentive is to operate without one. But if he does, the outcome is socially inefficient. Thus, when Chabar operates without a filter, the total daily gain to both parties is only $130 $50 $180, compared to $100 $100 $200 if Chabar had operated
with a filter. The daily cost of the filter to Chabar is only $130 $100 $30, which is smaller than its daily benefit to Fitch of $100 $50 $50. The fact that Chabar does not install the filter implies a lost daily surplus of $20.
Will Chabar dump toxins in the river? (Part 2) EXAMPLE 10.
Suppose the costs and benefits of using the filter are as in Example 10.3 except that Chabar and Fitch can now communicate with one another at no cost. Even though the law does not require him to do so, will Chabar use a filter? Recall the observation from Chapter 3 that when the economic pie grows larger, everyone can have a larger slice. Because use of a filter would result in the largest possible economic surplus, it would enable both Chabar and Fitch to have a larger net gain than before. Fitch thus has an incentive to pay Chabar to use a filter. For example, suppose Fitch offers Chabar $40/day to compensate him for operating with a filter. Both Chabar and Fitch will then be exactly $10/day better off than before, for a total daily net gain of $20. Their combined increase is exactly the increase in total daily economic surplus that results from using the filter.
In Example 10.4, what is the largest whole-dollar amount by which Fitch could compensate Chabar for operating with a filter and still be better off than before?
Ronald Coase, a professor at the University of Chicago Law School, was the first to see clearly that if people can negotiate with one another, at no cost, over the right to perform activities that cause externalities, they have the incentive to arrive at an efficient solution. This insight, which is often called the Coase theorem, is a profoundly important idea, one for which Coase (rhymes with “dose”) was awarded the 1991 Nobel Prize in Economics. 2 Why, you might ask, should Fitch pay Chabar to filter out toxins that would not be there in the first place if not for Chabar’s factory? The rhetorical force of this ques- tion is undeniable. Yet Coase points out that externalities are reciprocal in nature. The toxins do harm Fitch, to be sure, but preventing Chabar from emitting them would penalize Chabar, by exactly $30/day. Why should Fitch necessarily have the right to harm Chabar? Indeed, as Example 10.5 illustrates, even if Fitch has that right, he will exercise it only if filtering the toxins proved the most efficient outcome.
EXERCISE 10.1EXERCISE 10.
Coase theorem if, at no cost, people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities
Coase theorem if, at no cost, people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities
(^2) Ronald Coase, “The Problem of Social Cost,” Journal of Law & Economics , v. 3, October 1960, pp. 1–44.
Will Chabar dump toxins in the river? (Part 3)
Suppose the law says that Chabar may not dump toxins in the river unless he has Fitch’s permission. If the relevant costs and benefits of filtering the toxins are as shown in Table 10.2, and if Chabar and Fitch can negotiate with one another at no cost, what are Chabar’s incentives to filter the toxins? Note that this time the most efficient outcome is for Chabar to operate with- out a filter, for the total daily surplus in that case will be $220 as compared to only $200 with a filter. Under the law, however, Fitch has the right to insist that Chabar use a filter. We might expect him to exercise that right, since his own gain would rise from $70 to $100/day if he did so. But because this outcome yields a smaller surplus, we know that each party can do better.
EXAMPLE 10.
HOW EXTERNAL COSTS AND BENEFITS AFFECT RESOURCE ALLOCATION 307
We obtain the same outcome (no genetically modified barley) if we reverse the legal onus. If Bob does not have the right to grow genetically modified barley, and if he has to obtain the permission of his neighbours to do so, his potential gain of $100 is not enough to compensate his neighbours for their losses, so he cannot afford to buy them off. Therefore, regardless of whether Bob has the legal right to grow what he wants, or his neighbours have the right to prevent him from growing genetically modified crops without their permission, he will not grow genetically modifi ed barley. The direction of payment between Bob and his neigh- bours is of no consequence to his decision: it is the same whether he has to pay his neighbours for the external costs they bear if he grows genetically modified barley or they have to pay him to not grow genetically modified barley.
Table 10.3 shows the benefit that Bob will realize if he decides to grow geneti- cally modified barley and the external cost that his decision will impose on his neighbours. If Bob has the legal right to grow whatever crop he wants, and if he exercises that right, Table 10.3 shows that there will be a net loss to Saskatchewan society ($100 $400 $300). However, this potential loss can also be seen as the incentive Bob’s neighbours have to get him to not exercise his right. If each of his fi ve neighbours were to contribute $21, they could pay him $105 to not switch to genetically modified barley. Each farmer could pay $21 to avoid a loss of $ and therefore be better off, while Bob would be better off by $5 if he accepted their side payment and did not grow genetically modified barley.
TABLE 10. The Effects of Growing Genetically Modified Barley Bob’s Losses for Bob’s Profits Neighbours Net Gain/Loss Bob grows genetically $100 ($80 each) 5 400 300 modified barley
Notice that, in this example, the legal system defines rights; it establishes who must pay whom, but regardless of how those rights are assigned, the response to the problem of scarcity is the same. As Table 10.3 shows, Bob makes the same decision regardless of who pays whom, provided that negotiations between him and his neigh- bours are costless and perfectly informed. Either way, it is socially inefficient for Bob to grow genetically modified barley, and he therefore does not grow it. However, the assumption that negotiations are costless and perfectly informed is crucial. Bob’s information about his neighbours’ incentives might be incomplete. Suppose that one of Bob’s neighbours (let’s call him Dan) observes that Bob is receiving $105 in side payments for not doing something. If Dan decides that he too would like to be paid for not growing genetically modified barley, he can threaten to grow genetically modified barley, and demand a side payment. In fact, Dan is not the only one who is potentially eligible for side payments; any of Bob’s neighbours can also state that they are about to grow genetically modified barley. Who, then, will pay the side payments and who will receive them? The assumption of “perfect information” underlying the Coase argument is really quite a strong presumption, since it rules out the possibility of posturing, bluffing, and other strategic behaviour. Such game playing is more likely if the
HOW EXTERNAL COSTS AND BENEFITS AFFECT RESOURCE ALLOCATION 309
310 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
legal system is one where Bob (or Dan or anybody else) has to be paid to not exercise a legal right that is his and that he could easily exercise. In general, imper- fect information and transaction costs often mean that a system of side payments may not be able to function effectively. However, we still get the socially efficient outcome if the legal system requires Bob to compensate his neighbours for their losses because his gain from growing the new crop is not enough ($100) to pay them the full value of their $400 loss (5 $80 $400).
LEGAL REMEDIES FOR EXTERNALITIES We have seen that efficient solutions to externalities can be found whenever the affected parties can negotiate with one another at no cost, or at least at a cost that is less than the surplus that could be gained by negotiating. In the real world, bee- keepers and orchard owners do negotiate over what otherwise would be external benefi ts. But negotiation is not always practical. A motorist with a noisy muffler, for example, imposes costs on others, yet they cannot flag him down and offer him a payment to fix his muffler. If they could, we would then have to worry that some people might drive around with noisy mufflers just to attract payments from those who are bothered by the noise. In recognition of this difficulty, most governments simply require that cars have working mufflers. Indeed, the explicit or implicit purpose of a large share of laws is to solve problems caused by externalities; that is, to help people achieve the solutions they might have reached had they been able to negotiate with one another. When negotiation is costly, the task of adjustment generally falls on the party who can accomplish it at the lowest cost. For example, many municipal noise ordinances have restrictions on loud party music, which may take effect at a later hour on weekends than on weekdays. This pattern reflects costs and ben- efits because the gains from loud music tend to be larger on weekends while such music is more likely to disturb people on weekdays. By setting the noise curfew at different hours on different days of the week, the law places the burden on party- goers during the week and on sleepers during the weekend. Similar logic explains why noise ordinances allow motorists to honk their horns in most neighbour- hoods but not in the immediate vicinity of a hospital. Thus, laws and regulations are often used to control external costs. Governments can also use subsidies to encourage external benefits. It is worth emphasizing that the effectiveness of laws and regulations designed to correct externalities is closely related to existing norms or conventions of behaviour. Most people observe most laws most of the time, because they think it’s the right thing to do. Although the police and courts suppress the exceptions, compliance generally is greater than can be explained by the sheer weight of enforcement. If public support for a law is so low that a large number of people refuse to comply with it, the law is likely to be repudiated. The repeal of prohibition in the United States provides a particularly striking example. In 1919, the United States passed a constitutional amendment that prohibited the manufacture, transporta- tion, and consumption of alcoholic beverages. Problems with enforcement were so severe that the amendment was repealed in 1933.
THE OPTIMAL AMOUNT OF EXTERNAL COSTS IS NOT ZERO Because people think of pollution as bad, many cringe when they hear the phrase “socially optimal level of pollution.” How can any positive level of pol- lution be socially optimal? But to speak of a socially optimal level of pollution is not the same as saying that pollution is good. It merely recognizes that though
312 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
Economic analysis can help to design laws that will produce socially efficient outcomes, but one must also realize that the observance of those laws depends, crucially, on whether people think they are “fair” or “reasonable.” For instance, the Internet has made it easy to copy music without paying for it, even though the law states that musical artists are entitled to royalties when their music is copied. If millions of people continue to copy music files, it will not be practical to enforce the law on file sharing and it will fall into disuse. If musicians cannot collect royalties because laws on file sharing are unenforceable, then the right to collect royalties is, in effect, meaningless. 3
THE PROBLEM OF UNPRICED RESOURCES To understand the laws that govern the use of property, we must begin by asking why societies created the institution of property in the first place. The following examples, which show what happens to a valuable resource that nobody owns, suggest why property rights may sometimes help to produce socially efficient outcomes.
(^3) Property rights can be defined as the “…sanctioned behavioral relations among [individuals] that arise from the existence of things and pertain to their use.” A society’s system of property rights is “…the set of social and economic relations [that defines] the position of each individual with respect to the use of scarce resources.” Any individual who does not observe the norms specified by the system of property rights bears the consequences for nonobservance. Eirik G. Furubotn and Svetozar Pejovich, “Property Rights and Economic Theory: A Survey of Recent Literature,” Journal of Economic Literature, 10 , December 1972, p. 1139. Furubotn and Pejovich (p. 1139, n. 3) state that the definition is consistent with Roman Law, Common Law, Marx and Engels, and modern legal usage.
EXAMPLE 10.7 (^) How many steers will villagers send onto the commons?
A village has five residents, each of whom has accumulated savings of $100. Suppose that they each have two options for investing that money: buy government bonds or buy cattle. Each villager can either pay $100 for a bond that pays 13 percent interest per year or buy a one-year-old steer for $100 and send it onto the piece of land set aside for village use, the village commons, to let it graze for one year before selling it. The price the villager will get for the two-year-old steer depends on the amount of weight it gains while grazing on the commons, which in turn depends on the number of one-year-old steers sent onto the commons, as shown in Table 10.4.
TABLE 10. The Relationship between Herd Size and Steer Price Number of steers Price per two-year-old Income per steer on the commons steer ($) ($/year) 1 126 26 2 119 19 3 116 16 4 113 13 5 111 11
Note: The value of a yearling is $100 when it begins grazing. Income/steer is derived by sub- tracting $100 from the selling price of a two-year-old steer.
The price of a two-year-old steer declines with an increase in the total num- ber of steers grazing on the commons because less grass is available to each. The villagers make their investment decisions one at a time, and the results are public. If each villager decides how to invest individually, how many one-year- old steers will be sent onto the commons, and what will be the village’s total income? If a villager buys a $100 government bond, he will earn $13 of interest income at the end of one year. Thus, he will send a one-year-old steer onto the commons if and only if that steer will command a price of at least $113 when it is two years old. When each villager chooses in this self-interested way, we can expect four villagers to send a steer onto the commons. (Actually, the fourth villager would be indifferent between investing in a one-year-old steer or buying a bond, since he would earn $13 either way. For the sake of discussion, we will assume that in the case of a tie, people choose to be cattle ranchers.) The fifth villager, seeing that he would earn only $11 by sending a fifth steer onto the commons, will choose instead to buy a government bond. As a result of these decisions, the total village income will be $65/year: $13 for the one bondholder and 4($13) $52 for the four cattle ranchers.
Has Adam Smith’s invisible hand produced the most efficient allocation of these villagers’ resources? We can tell at a glance that it has not, since their total village income is only $65, precisely the same as it would have been had the possi- bility of cattle raising not existed. The source of the difficulty will become evident in Example 10.8.
What is the socially optimal number of steers to send onto the commons?
Suppose the five villagers in Example 10.7 confront the same investment oppor- tunities as before, except that this time they can make their decisions as a group rather than individually. How many one-year-old steers will they send onto the commons, and what will be their total village income? This time the villagers’ goal is to maximize the income received by the group as a whole. When decisions are made from this perspective, a one-year-old steer will be sent onto the commons only if its marginal contribution to village income is positive. As the entries in the last column of Table 10.5 indicate, the first steer clearly meets this criterion, since it increases total village income by $13. How? We see that when the first yearling is purchased and put onto the commons, total income from steers increases from zero to $26. Because the price of a yearling steer is $100, the villager who purchases a yearling must forego the purchase of a bond for $100. At an annual return of 13 percent on the $100, $13 is sacrificed to obtain $26. Marginal village income from the first steer is $13 ($26 $13 $13). A second steer causes total income from steers to increase by $12. However, if a second yearling is purchased instead of a bond, $13 is again sacrificed. Mar- ginal village income is $1, or a decrease of one dollar. Table 10.5 shows that as more yearlings are added after the first, ever larger reductions in total village income occur. In sum, when investment decisions are made with the goal of maximizing total village income, the best choice is to buy four government bonds and send only a single one-year-old steer onto the commons. The resulting village income will be $78: $26 from sending the single steer and $52 from the four government
EXAMPLE 10.
PROPERTY RIGHTS AND THE TRAGEDY OF THE COMMONS 313
THE EFFECT OF PRIVATE OWNERSHIP
As Example 10.9 illustrates, private ownership of the village’s grazing land offers one possible solution to the tragedy of the commons.
How much will a buyer pay for the right to control the village commons?
Suppose the five villagers face the same investment opportunities as before, except that this time they decide to auction off the right to use the commons to the high- est bidder. Assuming that villagers can borrow as well as lend at an annual interest rate of 13 percent, what price will the right to use the commons fetch? How will the owner of that property right use it, and what will be the resulting village income? To answer these questions, simply ask yourself what you would do if you had complete control over how the grazing land were used. As we saw in Example 10.8, the most profitable way to use this land is to send only a single steer to graze on it. If you do so, you will earn $26/year. Since the opportunity cost of the $ you spent on the single yearling steer is the $13 in interest you could have earned from a bond, your economic profit from sending a single steer onto the commons will be $13 per year, provided you can use the land for free. But you cannot; to finance your purchase of the property right, you must borrow money (since you used your $100 savings to buy a one-year-old steer). What is the most you will pay for the right to use the commons? Since its use generates an income of $26/year, or $13 more than the opportunity cost of your investment in the steer, the most you will pay is $100 (because that amount used to purchase a bond that pays 13 percent interest would also generate income of $13/year). If the land were sold at auction, $100 is precisely the amount you would have to pay. Your annual earnings from the land would be exactly enough to pay the $13 interest on your loan and cover the opportunity cost of not having put your savings into a bond. Note that when the right to use the land is auctioned to the highest bidder, the village achieves a more efficient allocation of its resources, because the owner has a strong incentive to take the opportunity cost of more intensive grazing fully into account. Total village income in this case will again be $78. If the annual interest on the $100 acquired from selling the land rights is shared equally among the five villagers, each will again have an annual investment income of $15.60.
EXAMPLE 10.
The logic of maximizing economic surplus helps to explain why the most commercial nations have well-developed private property laws. It also reminds us of the importance of compliance with laws and regulations. Some traditional societies have developed implicit rules for their commonly owned resources that restrict their use; for example, taboos on fishing on certain days. However, such arrangements are difficult for larger, more complex commercial societies to use. In such societies, property that belongs to everyone belongs, in effect, to no one. Not only is its potential economic value never fully realized, it usually ends up being of no value at all. Likewise, property rights that are not enforced by a legal system or that people completely ignore are tantamount to no property rights at all. Bear in mind, however, that in most countries the owners of private property are not free to do precisely as they want with it. For example, local zoning laws may give the owner of a lot in a residential area the right to build a three-storey house but not a six-storey house. Here, too, the logic of maximizing economic surplus applies, for a fully informed and rational legislature would define property rights so as to create the largest possible total economic surplus. In practice, of course, such ideal legislatures never really exist. Yet the essence of politics is the cutting of deals that make people better off. If a legislator could propose a change in the property laws that would
PROPERTY RIGHTS AND THE TRAGEDY OF THE COMMONS 315
316 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
enlarge the total economic surplus, she could also propose a scheme that would give each of her constituents a larger slice, thus enhancing her chances for re-election. As an economic naturalist, challenge yourself to use this framework when thinking about the various restrictions imposed on private property laws: zon- ing laws that constrain what you can build and what types of activities you can conduct on your land; traffic laws that constrain what you can do with your car; employment and environmental laws that constrain how you can operate your business. Your understanding of these and countless other laws will be enhanced by the insight that everyone can gain when property laws are defined so as to cre- ate the largest total economic surplus.
WHEN PRIVATE OWNERSHIP IS IMPRACTICAL Do not be misled into thinking that the law provides an ideal resolution of all problems associated with externalities and the tragedy of the commons. Defining and enforcing efficient property rights entails costs, after all, and sometimes, as in the following examples, the costs outweigh the gains.
Wild blackberries grow profusely at the edge of a wooded area in a crowded city park. The blackberries taste best if left to ripen fully, but they taste reasonably good if picked and eaten a few days early. Will the blackberries be left to ripen fully? Obviously, the costs of defining and enforcing the property rights to blackberries growing in a public park
are larger than the potential gains, so the blackberries will remain common property. That means that whoever picks them fi rst gets them. Even though everyone would benefit if people waited until the berries were fully ripe, everyone knows that those who wait are likely to end up with no berries at all. And that means that the berries will be eaten too soon.
ECONOMIC Naturalist
Why are blackberries in public parks picked too soon?
By 2001, traffic congestion in London was spiralling out of control. Motorists in central London spent 50 percent of their time in traffic jams. An estimated £2 to £4 million worth of time was being wasted every week. Everyone knew it was a problem, but drivers kept crowding onto the roads. Each person thought of roads as “common prop- erty” and considered only their own costs of travel time, ignoring the greater congestion and the increase in travel time that their presence on the roads caused. London mayor Ken Livingstone (a well-known left-wing politician) ran for election pledging to tackle traffic congestion. He
did it by using the market mechanism, and charging a price for using the central city roads during the day! Since February 2002, motorists entering designated central zones between 7:00 a.m. and 6:30 p.m. have had to pay a tax, originally £5 but now £8 per day. Around 230 cameras match car licence plates against a database of vehi- cles whose drivers have paid the charge, with a fine of £ levied on any motorist who fails to pay before midnight. The revenues have been used to subsidize more frequent bus service. When the charge came into operation, traffic levels instantly fell by 20 percent.
ECONOMIC Naturalist
Why does London, England, impose a tax on every vehicle that enters the central business district during business hours?
Here are some further examples of the types of tragedy of the commons that are not easily solved by defining private ownership rights. Harvesting Whales in International Waters Each individual whaler knows that harvesting an extra whale reduces the breeding population and hence the size of the future whale population. But the whaler also knows that any whale that is not harvested today will be taken by some other whaler. One solution would
318 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
TAXING POLLUTION Fortunately, alternative policies can distribute the cleanup more efficiently, even if the government does not know firms’ costs. One method is to tax pollution and allow firms to decide for themselves how much pollution to emit. The logic of this approach is illustrated in Example 10.10.
EXAMPLE 10.10 What is the least costly way to cut pollution by half?
Two firms, Sludge Oil and Northwest Lumber, have access to five production processes, each of which has a different cost and produces a different amount of pollution. For this example, assume that changes in their costs of production and prices are sufficiently small that they can stay in business for all the pollution con- trol options under consideration. The daily costs of the processes and the number of tonnes of pollution emitted are shown in Table 10.6. Pollution is currently unregulated, and negotiation between the firms and those who are harmed by pollution is impossible. Each firm can see that, because no reduction in pollution is required, process A is the cheapest to use. Therefore, both firms use process A, each one emitting four tonnes for a total of eight tonnes per day.
TABLE 10. Costs and Emissions for Different Production Processes Process A B C D E (tonnes of pollutant) (4 tonnes/ (3 tonnes (2 tonnes (1 tonne (0 tonne day) /day) /day) /day) /day) Cost to Sludge Oil ($/day) 100 200 600 1300 2300 Cost to Northwest Lumber ($/day) 300 320 380 480 700
The key idea illustrated in Table 10.6 is that the cost of reducing pollution often varies according to the source of pollution. In general, it is possible—but usually costly—to reduce pollution by choosing a cleaner production process. If all firms had the same costs of reducing pollution, the government’s decision would be simple: impose the same regulation on all firms. But when the costs of reducing pollution vary, there is an efficiency issue. If, in our example, the govern- ment wants to reduce total emissions by half, what is the efficient distribution of pollution abatement between the firms? A graph of the marginal abatement cost for Sludge Oil and Northwest Lumber can help us solve this problem. Consider the first row of Table 10.6. It tells us that if Sludge selects process B instead of process A, it will increase its total daily cost of production from $100 to $200 and reduce its daily emissions by one tonne; its marginal cost of abatement is $100, point b in Figure 10.2. (Alternatively, if reducing dirty air is equivalent to producing clean air, this can be described as the marginal cost of cleaner air.) If Sludge selects process C instead of process B, its total daily cost of production will increase from $200 to $600 and its daily emissions decrease by another tonne. This time, Sludge’s marginal abatement cost is $400, point c in Figure 10.2. Sludge can determine its schedule of marginal abatement cost by considering what happens to its total daily cost of production as it moves from the dirtiest to the cleanest production process. Sludge’s marginal abatement cost is graphed as MAC (^) S , the blue line bcde in Figure 10.2. The same process of plotting the increase in cost of production caused by reduc- ing pollution by one more tonne will result in Northwest’s marginal abatement
FIGURE 10. Marginal Abatement Cost for Sludge Oil and Northwest Lumber The line labelled MAC (^) S represents Sludge Oil’s marginal abatement cost; i.e., its cost of producing clean air. Curve MAC (^) NW shows Northwest Oil’s marginal abatement cost. The labelled points on the curves are the production process options of Table 10.6. The curves pertain if marginal abatement costs are continuous.
MAC NW
MAC s
Pollution abatement (tonnes/day)
Cost($/day)
0 1
b a A
B
C D
E
c
d
e
2 3 4
Tax 100
101
200
300
400
500
600
700
800
900
1000
cost, MACNW, the red line BCDE in Figure 10.2.^4 If each firm is required to cut pollution by half, each must switch from process A to process C. The result will be two tonnes/day of pollution for each firm. The increase in cost due to the switch for Sludge Oil will be $600/day $100/day $500/day. The increase in cost to North- west Lumber will be $380/day $300/day $80/day. Requiring both firms to cut pollution by the same amount therefore has a total cost of $580/day. Consider now how each firm would react to a tax of $40/tonne of pollution. If a firm can cut pollution by one tonne/day, it will save $40/day in tax payments. Whenever the cost of cutting a tonne of pollution is less than $40, each firm has an incentive to switch to a cleaner process. Thus Sludge Oil would continue to use process A, because switching to process B would cost an additional $100/day but would save only $40/day in taxes. Northwest Lumber, however, would switch to process B, because the $40 saving in taxes would be more than enough to cover the $20 cost of switching. However, a tax of $40 results in a reduction of only one tonne per day, three tonnes short of the four-tonne target. Suppose instead that the government imposed a tax of $101/tonne. Sludge Oil would then adopt process B, because the $ daily cost of doing so would be less than the $101 saved in taxes. Northwest Lum- ber would adopt process D, because for every process up to and including D, the cost of switching to the next process would be less than the resulting tax saving. Overall, then, a tax of $101/tonne would result in the desired pollution reduc- tion of four tonnes per day. The total cost of the reduction would be only $280/day ($100/day for Sludge Oil and $180/day for Northwest Lumber), or $300/day less than when each firm was required to cut its pollution by half. Notice that, in this example, once there is a tax on pollution, the firm benefits from reducing pollution by avoiding a tax of $101 per tonne. In fact, the firm’s marginal benefit from any activity that reduces its pollution by one more tonne is exactly the amount of the tax. Hence, the decisions of both Sludge and Northwest include the same type of cost–benefi t comparison that is a part of their other production decisions: reduce
(^4) To keep things simple, in Table 10.6 we measured pollution in one-tonne increments, so the points in Figure 10.2 are labelled to correspond. In many real-world situations, it is feasible to vary emissions by much smaller changes; if so, a firm’s marginal abatement cost can be represented by continuous lines.
ENVIRONMENTAL POLICY AND EXTERNALITIES 319
COST– BENEFIT
a permit. (This is the trade part of a cap-and-trade system.) This plan allows the government to enforce limits on pollution without requiring them to know the mar- ginal abatement cost of individual firms_._ Each firm’s marginal abatement cost is a commercial secret and neither firm knows the other’s schedule. Sludge Oil’s two free permits allow it to emit two tonnes/day, so it can pro- duce at point c in Figure 10.2. But each additional pollution permit will entitle it to increase its daily emissions by another tonne while avoiding the cost of abat- ing that tonne. Sludge’s MAC line in Figure 10.2 indicates that reducing its daily abatement from two to one tonne/day will cause its daily abatement cost to fall by $400/day. Sludge realizes that buying a pollution permit for any price less than $400 and using process B will be more profitable than not buying the permit and using process C. Sludge does not know Northwest’s marginal abatement costs, but if Sludge decided to test the water by offering to purchase a permit for $ and that offer is accepted they will be better off by $100. On the other hand, Northwest similarly starts with two free pollution permits and the option of being at point C in Figure 10.2_._ But its MAC line in Figure 10. shows that it will be better off if it can sell one permit for any price greater than its own marginal abatement cost. Hence, because Northwest can increase its daily abate- ment from two to three tonnes at a marginal cost of $100, the sale of one permit at a price of $300 will result in a net gain of $200. The cost–benefit principle tells both firms that they will be better off if they make the transaction, and one permit is sold by Northwest to Sludge for $300. This authorizes Sludge to increase its daily emis- sions by one tonne, but requires Northwest to exactly offset the increase by reducing its daily emissions by one tonne so that total daily emissions remain unchanged_._ Will another permit change hands? As its marginal abatement cost schedule shows, Sludge knows that if it acquires a fourth permit, it can switch from process B to A and increase its daily emissions from three to four tonnes, which means that it can reduce its daily abatement to zero and avoid a marginal abatement cost of $100. The most Sludge will pay for another permit is $100. Northwest’s marginal abatement cost schedule indicates that if it sells its last permit, it must increase its daily abatement from three to four tonnes at a marginal abatement cost of $220. So Northwest will not accept any price less than $220 for its last permit, a price that exceeds what Sludge will offer. In equilibrium, Northwest keeps one permit and sells one, operating at point D on its marginal abatement cost schedule, while Sludge buys an additional per- mit and operates at point B on its marginal abatement cost schedule.
COST– BENEFIT
COST– BENEFIT
EQUILIBRIUMEQUILIBRIUM
Pollution taxes and transferable pollution permits recognize that the atmo- sphere’s ability to absorb waste is limited. Both abatement mechanisms have been designed by economists as solutions to the problem of excessive polluting that occurs when the cost of emitting pollution is ignored. A tax on pollution makes polluters aware of the cost of using the atmosphere for waste disposal, and the tax revenues constitute a valuable stream of income that governments can use for other purposes. If an emissions permit system is introduced, the right to pollute becomes a valuable asset. When the permits are auctioned off the government gets the revenue, but if they are granted to polluters free of charge there is a windfall gain for those who receive them and the elimination of a potential revenue source for the government (The foregone revenue is likely to be substantial; in the U.S., the Congressional Budget Office estimates that the total could be between $50 bil- lion and $300 billion annually by 2020). 6 (^6) Congressional Budget Office, “Issues in Climate Change: Statement of Peter R. Orszag, Director, Presentation for the CBO Director’s Conference on Climate Change,” November 16, 2007, p. 10. For a brief summary of the issues, see: http://www.cbo.gov/ftpdocs/87xx/doc8769/11-01-CO2Emis- sions.pdf and http://www.cbo.gov/ftpdocs/80xx/doc8027/04-25-Cap_Trade.pdf.
ENVIRONMENTAL POLICY AND EXTERNALITIES 321
322 CHAPTER 10 EXTERNALITIES AND PROPERTY RIGHTS
Why might a government decide to give away such a valuable asset and grant polluters permits free of charge? Proposals for a pollution tax are likely to incite resistance from companies who now have to pay them, and these political pres- sures may imply that government gives away permits or sells them for less than market value.
RECAP ENVIRONMENTAL POLICY AND EXTERNALITIES An effi cient program for reducing pollution is one for which the marginal cost of abatement is the same for all polluters. Taxing pollution has this desirable property, as does a system of pollution permits. A system of permits has the advantage that regulators can achieve a desired abatement target without having detailed knowledge of the abatement technologies available to polluters. However, a pollution tax gives the government a stream of rev- enue that will not be available from permits unless the government sells them at full market value. An ideal policy, be it a tax or a system of permits, will put a price on pollution and give individuals and firms an incentive to recog- nize its full cost when making economic decisions.
10.4 (^) POSITIONAL EXTERNALITIES
In professional sports and a host of other competitive situations, the rewards people receive typically depend not only on how they perform in absolute terms, but also on how they perform relative to their closest rivals. In these situations, competitors have an incentive to take actions that will increase their odds of winning. Someone who consistently wins major tennis tournaments will claim big prizes and be presented with lucrative opportunities to endorse products. Second- or third-place finishers will claim smaller prizes and will receive fewer and less valuable opportunities to make endorsements. Nevertheless, runners-up will earn at least the opportunity cost of their efforts; otherwise, they will stop being professional tennis players and enter some other occupation.
PAYOFFS THAT DEPEND ON RELATIVE PERFORMANCE Suppose an individual tennis player can increase her chances of winning by hiring a personal fitness trainer and a sports psychologist, provided no other player does so. If she does not hire a trainer and a psychologist and her competitors do, her chances of winning will be greatly reduced. If every player knows this situation to be the case, they all will hire personal fitness trainers and sports psychologists, because anyone who fails to do so will have greatly diminished chances of win- ning tournaments. Now suppose that spectators and those who pay athletes to endorse products will pay exactly the same amount regardless of whether the players hire personal trainers and sports psychologists—to the fans and sponsors, tournaments are of the same value either way. If additional resources are employed to obtain what spectators and sponsors regard as the same output, there can be no gain for spectators, sponsors, and athletes as a group. Indeed, when more resources are employed to obtain the same thing, total economic surplus must be smaller. To the extent that each contestant’s payoff depends on his or her relative perfor- mance, then, the incentive to undertake such investments will be excessive from a collective point of view. Consider the following example.
